beached] a |3| Financial Management 25.7 Udar Limited is considering a change in its credit terms from 2/10, net 30 to 3/10. net 45. This change is expected to (a) increase the total sales from Rs.50 million to Rs.60 million (b) decrease the proportion of customers taking discount from 0.70 to 0.60 (©) increase the average collection period from 20 days to 24 days. ‘The gross profit margin for the firm is 15 percent and the cost of capital is 12 percent. The tax rate is 40 percent. Calculate the expected change in residual income 25.8 The financial manager of a tirm is wondering whether credit should be granted to a new cus- tomer who is expected to make a repeat purchase. On the basis of credit evaluation, the financial manager feels that the probability that the customer will pay is 0.85 and the probability that the customer will default is 0.15. Once the customer pays for the first purchase, the probability that ‘he will pay tor the repeat purchase increases to U.95. Ihe revenues trom the sale will be Ks.1U,00U and the cost of sale would be Rs.8,500—these figures apply to both the initial and repeat pur~ chase. Should credit be granted? 25.9 A firm is wondering whether to sell goods to a customer on credit or not. The revenues from sale will be Rs.10,000 and the cost af sale will be Rs.8,000. What should be the minimum probability that the customer will pay, in order to sell profitably? Multitech Limited, set up by a few technocrats in the mid 1990s, enjoyed a fairly healthy growth rate till two years ago. Intense competition in the last few years has slowed down the growth rate considerably, The present sales of Multitech is Rs. 800 million. In a recent executive committee meeting, Jeevan Reddy, the marketing director, argued for relaxing the credit policy of Multitech to stimulate sales increase. Gautam Singhvi, the finance director, promised to consider this request favourably, provided the relaxation in credit policy had a positive impact on residual income. The present credit policies of Multitech are as follows: Credit Standards Multitech classifies its customers into 4 categories, 1 through 4. Credit rating diminishes as one goes from category 1 to category 4. Customers in category 1 have the highest credit rating whereas customers in category 4 have the lowest credit rating. Currently Multitech extends mited credit to customers in categories 1 and 2, limited credit to customers in category 3, and no credit to customers in category 4. Credit Period Multitech provides 30 days of credit to its customers who are deemed eligible for credit under its credit standards Cash Discount To induce its customers to pay early, Multitech offers cash discount. Its credit terms are 1/10, net 30. You have recently joined Mullitech ay 4 financial analyst and Gautam Singhvi has asked you examine the effect of relaxing credit standards, extending the credit period, and providing more gener ous cash discount After talking to executives in the marketing, production, and finance departments you have gath- ered the following information. = Presently the proportion of credit sales and cash sales are 0.7 and 0.3 respectively .50 percent of the customers (by value) who are granted credit avail of cash discount.Bache Tene Credit Management [=| ‘The contribution margin ratio for Multitech is 20 percent. the tax rate for Multitech is 30 percent. the post-tax cost of capital for Multitech is 12 percent, and the average collection period (ACP) on credit sales is 20 days. If the company extends unlimited credit to customers in category 3 and limited credit to custom- ers in category 4, the sales of the company would increase by Rs. 50 million on which the bad debt losses would be 12 percent. The ACP, however, will remain unchanged at 20 days. If the company extends ity credit period from 30 days to 60 days, its sales ty customers who are ‘granted credit will increase by Rs. 40 million. Further, the percentage of customers who will avail of cash discount will decrease to 20 percent. The ACP, as a result of the extension of the credit period, will increase to 50 days. If the company relaxes ils discount teruts (v 2/10 net 30, its sales Lo Custumers who are granted credit will increase by Rs. 20 million. Further, the percentage of credit customers who will avail of cash discount will increase to 70 percent and the ACP will decrease to 16 days. (a) What will be the effect of relaxing the credit standards on residual income? (b) What will be the effect of extending the credit period on residual income? (c) What will be the effect of relaxing the cash discount policy on residual income? Examine the impact of these credit policy changes one ata time.